The 12 members of the Federal Reserve’s rather dull-sounding Federal Open Market Committee (FOMC) have considerable sway over the global economy through their pulling of the levers of US monetary policy. The central bank’s vice-chair, Lael Brainard, nodded to this in a September speech in New York when she linked higher US rates to “cross-border spillovers and financial vulnerabilities” in other parts of the globe.
The evidence is clear on this point - both in 2022 and throughout the 50 years since the dollar was delinked from gold in 1971. This year, as US rates have risen to combat soaring inflation, capital has flowed away from less stable emerging economies and towards the US, helping lift the dollar's value against a basket of other currencies to its highest level since the turn of the millennium. Emerging markets specialist Ashmore’s (ASHM) shares are down by more than 40 per cent over the past 12 months as investors have fled riskier markets.
Emerging economies are more reliant on imports and many have significant dollar-denominated debts. A stronger US dollar makes financing more costly and pushes up the price of crucial imported commodities such as oil. IMF loans have reached a record high this year as economies such as Egypt and Pakistan have sought bailouts. Sri Lanka defaulted on its foreign debt in May, and S&P Global Ratings recently warned in its fourth-quarter outlook report on emerging markets that continued dollar strength “could fuel tensions and trigger social unrest, particularly for emerging markets with limited fiscal space or high debt”.
But while such prognoses are stark, none of this is particularly surprising. A glance back over recent history reveals several examples of how the Fed’s tightening has a direct and material impact on emerging markets.
An often-referenced case is Latin America's ‘lost decade’ in the 1980s, which resulted from the large interest rate rises pushed through by the Fed under Paul Volcker, who was chairman between 1979 and 1987, and who faced an inflation rate of 14 per cent as oil prices surged. The US prime lending rate hit 21.5 per cent, which drove US unemployment into double-digits but which ultimately dampened down spiralling prices at home.
As well as Latin America, Africa and other parts of the developing world were severely impacted by the Fed's rate hikes. High levels of dollar-denominated debt left these countries at the mercy of floating interest rates. Higher US rates led to a debt crisis which, combined with plummeting commodity prices, resulted in capital flights and a severe contraction in GDP per capita. Before debt relief came along, deep austerity programmes and mishandled privatisations led to a decade of stagnation.
Another emerging market nightmare spurred on by Fed tightening was the exotically-dubbed 'Mexican tequila crisis' of 1994. While political instability also has a major part to play in this tale, the FOMC’s decision to raise rates six times that year made Mexico a significantly less attractive destination for international capital. The real exchange rate of the peso against the dollar fell by more than 40 per cent over five months and the Bank of Mexico had to abandon its policy of pegging to the dollar. Aid was needed from the IMF, the Bank for International Settlements, and the US Treasury. This prevented a Mexican default, but not a deep recession.
Then, just a couple of years later in 1997, the Asian financial crisis erupted. The value of currencies and stocks plummeted in countries across the region, with Thailand, Indonesia, Malaysia, and South Korea hit hard. Many currencies were pegged to the dollar, which meant that the Fed's tightening of policy under chairman Alan Greenspan - the federal funds rate was raised to 5.5 per cent by March 1997 and almost doubled between 1994 and 1995 - was a key external shock to go alongside weakening domestic situations. Big current account deficits, sizeable dollar-denominated debts, and weak export rates meant that once Thailand had to go to the IMF over a foreign exchange reserves crisis the contagion spread across the region as markets panicked. The outcome was huge IMF bailouts and reform packages to prevent economic catastrophe. It is worth noting that the US markets went through a sizeable mini-crash themselves during this episode.
Analysts hold mixed opinions on how severe the impact the Fed’s tightening will be on emerging markets this time around. In a recent paper for the Federal Reserve Bank of Dallas, authors Scott Davis, Michael Devereux, and Changhua Yu stated that major emerging economies “are in a much safer place than they were in 1994”. Mexico has a smaller current account deficit and lower foreign debts; Brazil has tightened monetary policy early. But while foreign exchange reserves have improved for many emerging economies, IMF data suggests stocks are being burned through quickly.
The power of the Fed remains an irritant for many. European Union high representative Josep Borrell complained in a speech at an ambassadors conference in Brussels earlier this month that “everybody has to follow [the Fed], because otherwise their currency will be devalued”. Given the centrality of the dollar to global trade, there is little indication that this situation will change anytime soon. And the historical record is clear: emerging markets have much to fear from the Fed raising rates.
